Whether On Retirement Of Partner From The Firm Is Liable To Tax On Excess Amount Received ?

Question :
Mr. A retired from a partnership firm. Upon retirement, the assets of the firm are revalued and the excess amount is credited to each partner’s capital account. Mr. A is paid the amount standing to his capital account [which is inclusive of revaluation amount]. What would be tax implications in the hands of the firm and/or in the hands of the Mr. A?

Will the position be different if:

(i) Instead of revaluation being carried out in the books of account, a lump sum huge amount is paid to Mr. A by drawing up a memorandum of settlement.

(ii) The amount paid to Mr. A is debited to the rest of the partners’ account or is debited goodwill account of the firm.

(iii) There is admission of a new partner who brings the amount required to be paid to Mr. A and who is given the same share as of Mr. A

(iv) There is no new admission and the existing partners distribute the share of Mr. A equally /unequally.

Answer :
Section 45(4) of the Income-tax Act, 1961 provides that, profits or gains arising from transfer of capital assets by way of distribution of capital assets on dissolution of a firm, association, etc. “or otherwise” shall be chargeable to tax as income of the firm, association, etc. of the previous year in which the said transfer takes place and for purpose of section 48, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as a result of the transfer.

Further, section 45(4) refers to “transfer” by way of distribution. The expression ‘distribution’ means an apportionment amongst several persons. It connotes something actual and not something notional. It implies a distribution in specie and not distribution of sale proceeds. [See James Anderson vs. CIT 39 ITR 123 (SC)]. It could be physical, it could also be constructive [See Punjab Distilling Industries Ltd. vs. CIT – 56 ITR (SC)].

Since the assets are not distributed to partners, no liability in the hands of firm, on retirement of ‘A’,

Now, in this case, the assets of the firm are revalued and excess amount is credited to each partner’s capital account. Thereafter, ‘A’ retired from a firm and on his retirement, the amount standing to his capital account has been paid. So, as per the Bombay High Court in CIT vs. A. N. Naik Associates, no liability as there is no transfer of any asset and account is settled in cash.

The position would remain the same, even if there is no revaluation of assets and huge amount is paid to ‘A’ by drawing up a memorandum of settlement, or amount paid to ‘A’ by debiting the rest of partners or new partner brings the amount and pays to ‘A’.

However, if a retiring partner assigns, releases and relinquishes his interest and share in the partnership in favour of continuing or new partner, it amounts to “transfer “ and liable to tax as per Tribuvandas G. Patel vs. CIT [236 ITR 515 (SC)] and CIT vs. H. R. Aslot [115 ITR 255 (Bom) (HC)


How Assets and Liabilities can be settled upon Dissolution of Partnership?

You will not find answer to this question in Income tax Act. You will find answers in section 263 of Indian contracts Act 1872 and section 48 of Indian partnership Act.

Section 263 of the Indian Contract Act, 1872, provides that after dissolution of partnership, the rights and obligations of the partners continue in all things necessary for winding-up the business of the partnership. In the normal course there must be a general sale and winding up followed by a distribution of the surplus.

(1) In all cases of dissolution, assets of the firms have to be realized and converted into money. No one can insist on retaining his share unsold. Liquidation of assets and realization by sale is the normal feature of winding up. The value can be realized on the footing of an actual sale or a notional sale as is made clear by Supreme court in various cases.

(2) In the case of notional sale specific items of properties can be allotted to one of them and the money value to the other. This distribution is only part of the adjustment of the rights between these persons. Such distribution and adjustment of rights is a necessary consequence of dissolution of the partnership and cannot in law amount to a transfer.

(3) Distribution of surplus assets of an erstwhile partnership is only an adjustment of rights of parties and, does not involve a transfer of title from one party to the other. It is also significant to note that for such a distribution there is no consideration. Hence distribution of assets following dissolution can-not be treated as “conveyance”.

(4) Various High Courts in India have taken the view that the process by which distribution of surplus assets takes place between partners inter se or between a partner and representative of a deceased partner, does not involve a transfer or conveyance. Such a view has been also been approved by Supreme court in Commissioner of Income Tax, U. P. vs. Bankey Lal Vaidya

(5) and Commissioner of Income Tax, M. P., Nagpur and Bhandara v. Dewas Cine Corporation has approved this view.

Section 48 of the Partnership Act provides as follows as regards settling of accounts after dissolution,:“In settling the accounts of a firm after dissolution, the following rules shall, subject to agreement by the partners, be observed :

  • Losses, including deficiencies of capital, shall be paid first out of profits, next out of capital, and lastly, if necessary, by the partners individually in the proportions in which they were entitled to share profits.

(b) The assets of the firm, including any sums contributed by the partners to make up deficiencies of capital, shall be applied in the following manner and order : –

(i) in paying the debts of the firm to third parties;

(ii) in paying to each partner ratably what is due to him from the firm for advances as distinguished from capital;

(iii) in paying to each partner ratably what is due to him on account of capital; and

(iv) the residue, if any, shall be divided among the partners in the proportions in which they were entitled to share profits.”

In the case death of a partner, all that the estate of the deceased partner would be entitled to, will be the proportion of the partnership assets after having been realized and converted into money and all the debts and liabilities of the partnership having been paid and discharged. This alone is the content of the right of the deceased partner. What, therefore, happens on death of a partner is that his share in the partnership is given back to him (to his legal heir) normally by well-accepted commercial methods of valuation and the value of his share is quantified in terms of money. The purpose of making the valuation is to determine the share of the deceased partner so as to be paid in terms of money, and on such payment the remaining assets of the partnership continue to belong to the surviving partner.

Acquisition of interest in the partnership

For acquisition of interest in the partnership firm, there must be a mode by which the interest must pass. If there is no process by which a transfer of interest can be said to have taken place in respect of the interest of the deceased, what the estate of the deceased partner gets is only the money value of the interest of the deceased partner. Therefore, the High court of Bombay in Commissioner of Income Tax, Bombay City-III vs. Patel Brother held that in case of death of a partner where moneys are paid to the estate of the deceased partner in lieu of his share in the partnership, there is no acquisition of any interest by the surviving or continuing partner.

What happens to Subsisting Contracts?

Section 45 of the Indian Contract Act provides that- When a person has made a promise to two or more persons jointly, then, unless a contrary intention appears from the contract, the right to claim performance rests, as between him and them, with them during their joint lives, and, after the death of any of them, with the representative of such deceased person jointly with the survivor or survivors, and, after the death of the last survivor, with the representatives of all jointly.

Assignment of Prior Contracts: How this can be worked out is that the legal representative of the deceased partner while receiving what was due to the deceased partner in respect of his share, may assign his interest by a deed or he may, instead of assigning his interest, take the amount due to him from the firm and give a receipt for the money and acknowledge that he has no more claim on his surviving partner. The former type of transactions will be regarded as sale or release or assignment of his interest by a deed attracting stamp duty while the latter type of transaction would not. If the surviving partner agrees to pay a lump sum in consideration of the legal representative of the deceased partner assigning or relinquishing his share or right in the partnership and its assets in favor of the surviving partner, the transaction would amount to a transfer within the meaning of section 2(47) of the Income Tax Act. The steps for assignment of prior contracts to a new partnership firm or company formed for this purpose can be summarized as follows-

Step 1: Settlement of Accounts followed by a distribution of the surplus.

Step 2: Issue of No Objection / Release Letter from Legal Heir

As noted above, the legal representatives of the deceased partner can either- (a)assign their interest in the firm (by virtue of being legal heir) by way of an assignment deed, or (b) take the amount due to the deceased partner from the firm and give a receipt for the money andacknowledgement that they have no more claim on the surviving partner.

Step 3: Novation of Subsisting Contracts

Step 4: Termination of Contracts

The subsisting contracts may be required to be terminated in either of the two cases- (a) the other party to the contract does not agree to such assignment to this newly formed company or (b) the contract does not allow assignment. In both of these cases, the process for termination as laid down in that contract will be required to be followed.

Can Share Application money be more than Authorized Share Capital ?

The company’s share capital should never exceed the Authorized Share capital. But we have to understand the difference between Share Application Money & Share Capital.

Share Capital, is the result of shares already allotted. But Share Application money is the money received from the public or directors in case of private company, for which share allotment is pending. Now the issue that arises is

1. Can a company have Share Capital more than Authorized share capital – The answer as we all know is “No”. No company can have its Issued, paid-up and subscribed capital more than its Authorizes Share Capital.

2. Can a company have Share Application money more than its Authorized Share Capital – There is a controversy in this particular case. We may say how can a company invite share application money, when it has no Authorized share capital limit. As per some experts, they say the share application money cannot be more than Authorized Share Capital and some say it can.

Let us for the time being understand till what period the share application money can be kept by the company.

The provisions of sec.69(4) of the companies act, would come into picture which says. all the moneys received from applicant for shares shall be deposited and be kept deposited in a schedule bank, subject to specified conditions. However, these provisions do not apply to a private company. Therefore there is no time limit to retain the said money. But  indirectly. Sec.205C read with Investor Education and Protection Fund rules, states that application money received by companies

-for allotment of securities
-due for refund and interest accrued on it or
-not claimed for a period of 7 years from the date they become due for payment should be transferred to the said fund.

This provision is applicable to all companies. The question of the date of refund or payment will arise only when the company mentions those dates in any of its application at the time of receipt of funds or thereafter. In case, the company does not mention those dates, then the Private Company can take advantage of the same and retain the share application money for unlimited period.

Since, we have understood about the time period for which the Share Application money can be retained, let us know whether this share application money can be more than the Authorized Share Capital

As per the companies act, 1956 there is no restriction on the quantum. But in practice, the companies retain the share application money over and above the Authorized share capital limit. Shareholders, who are aware of their legal rights may force the company to make allotment of shares or to refund their money. It is at this point of time, the question of oppression and mismanagement has come into the picture. As a result of which to protect the public, the Registrar of Companies empowered by Section 614 of the Companies Act, 1956 may direct the Companies to make allotment of shares or to refund the amount.

Though no restriction is imposed by the Companies Act, 1956 a judgment in the case of ITO Vs.Nandi Promoters (P) Ltd, pronounced has made it clear that, a company cannot have Share Application money more than the Authorized Share Capital.

Wherein, the A.O. found that :
– the authorized share capital of the company was Rs.1 lakh only
– the share capital of the company has not been increased till passing of the assessment order
– the shareholders were also aware that they company did not intend any increase in share capital, and in fact no application for increase has been filed

Under these circumstances, how can the company receive money under the cover of share application money.

Finally, after several hearing, tribunal has allowed the appeal of revenue and concluded with the following facts:

The assesses company has declared that the amount has been received towards share application money from one of its directors which was more than the authorized capital. The assessee has not taken into consideration the provisions of company law for increasing the authorized capital. A procedure has been prescribed under the companies act and other applicable laws for increasing the authorized capital. Ignoring the same, one cannot declare that any cash received is the money received towards share application money.

Hence, no company can receive any money more than its Authorized Share Capital under the Cover of Share Application Money.

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Can LLP be partner in partnership firm

LLP is a separate and distinct entity form its members. LLP is capable of entering into contract and can own property etc as altogether separate entity in its own name. Can LLP be admitted as partner into partnership firm ?

LLP being a partnership firm cannot be a partner of another firm on the logic that the partnership firm does not be a legal person with distinct and separate identity . Mere registration of an LLP does not create a corporate identity of the firm called “juristic person”, it only gives its partners immunity from being personally liable.

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